Salon Radio: Notre Dame finance professor Richard Sheehan

Several key claims from Hank Paulson are inaccurate and misleading. Plus: Paulson's role in the financial crisis he's now supposed to solve.


Glenn Greenwald
September 23, 2008 9:03PM (UTC)

[updated below (w/transcript) - Update II]

University of Notre Dame Professor of Finance Richard Sheehan has been one of the most incisive economist-critics of the Paulson plan since it was unveiled, and he's my guest today on Salon Radio. We discuss the ways in which the key fear-mongering claims of Paulson have been both misleading and exaggerated; the reasons the bailout plan won't work even if the best case scenario occurs; where and how the Federal Government will get $700 billion to fund it; and the role Paulson himself has played in the events that have caused this crisis. From Professor Sheehan in the interview:

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Unfortunately, Mr. Paulson was among those that were creating the problem, rather than warning about the problem. In his role as CEO of Goldman Sachs, Goldman -- under his watch -- created a whole lot of CDOs [collateralized debt obligations] that now are under the heading of "toxic waste." So it's amusing in a twisted way to look at him now as the one who is going to save us from imminent financial collapse, when it was at least in part brought on by the actions of Goldman, in terms of being so liberal in their willingness to create new and improved CDOs.

The interview can be heard by clicking PLAY on the recorder below. It is roughly 20 minutes and a transcript is here.

Tomorrow on Salon Radio: Digby, to discuss this important post about the severe political risks for the Democrats generally, and the Obama campaign specifically, from having the Democratic Congress voting for a bailout plan.

UPDATE: On an unrelated note, Bob Woodward is currently at FireDogLake answering questions about his new book. I asked him this question about the claim Woodward made last week that the U.S. has achieved a new technological "breakthrough" allowing it to use a super-innovative and advanced weapon in Iraq (which Woodward says he knows about but refuses to describe), and Woodward's reply to my question is here (and my further reply/question is here). Woodward will be at FDL for the next hour (until 4:00 p.m. EST) answering questions in the comment section.

UPDATE II: Without commenting on all of her recommended policies, this is really good, effective and strong political messaging from Rep. Marcy Kaptur (D-Ohio):

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Interview with Professor Sheehan here:

This interview can be heard by clicking PLAY on the recorder below:

Glenn Greenwald: My guest today is Richard Sheehan, who is a professor in the Department of Finance at the University of Notre Dame, and we're here to discuss the pending/on-going financial crisis, and some of the controversies surrounding the various bailout plans. Thanks very much, Professor Sheehan, for joining me today.

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Richard Sheehan: Thank you for having me.

GG: My pleasure. So, I want to begin by asking you about what is really defining and shaping the public debate over this financial crisis, which is the claim made very early on by Treasury Secretary Paulson and Ben Bernanke, that, absent the kind of intervention that they've called for, that the financial markets were literally days away from grinding to a complete halt or collapsing altogether. I think there's a fair consensus among most people - if not everyone - that the crisis is very real and that some type of intervention of some sort is necessary, but how accurate have those claims been that have really framed the entire discussion that we were days away from a collapse and that only a federal government bailout of the type they propose can avert that disaster?

RS: I think there's a kernel of truth there, but I think there's a lot of misleading statements that have been made and the question I think is: how deliberate were those misleading statements? There certainly is a problem in terms of liquidity, and in order to understand that, though, I think it's important to consider who exactly has the biggest liquidity problems and -- even more fundamentally - who doesn't have liquidity problems or at least who doesn't have a liquidity problem now.

So, Paulson and Bernanke have given the impression that this is widespread, that the entire financial system is on the verge of collapse, and I think you need to be very, very careful and to draw the distinction between who's on the brink, or close to the brink, and who is perhaps getting closer but still a long way away.

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And your typical bank, your neighborhood bank, and virtually the entire banking system, TRIF's, credit unions, savings and loans - all of those are perhaps not in the shape that they'd like to be in, but they're nowhere near a precipice. They're not in any tremendous danger in most cases, and there simply isn't a financial crisis on their end.

Where you do have the problem, however, is with investment banks, with some firms on Wall Street, with some insurance companies. Basically, anyone that has a large exposure, a large fraction of their portfolio tied into, in particular sub-prime mortgages, or some other more esoteric financial instruments - that's where you have a fundamental issue.

GG: Okay. I think that in the public's mind, that distinction is fairly well established, that it isn't necessarily traditional banks, or as you call them, neighborhood banks, who right this moment are on the verge of collapse, but instead the financial services industry -- the investment banks and insurance companies that have traded and relied upon these more complex derivative instruments and mortgage-related securities, and the argument that Bernanke and Paulson have been making is that, if those limited number of institutions fail, given their centrality to the way our markets work, that the credit market has almost dried up, and would have dried up almost completely, which then in turn would have led to the collapse of the rest of the system including the smaller institutions that are relatively safe.

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Is that an accurate assessment in your view of what we were days away from seeing?

RS: It could be, but it's not necessary. It wouldn't necessarily happen. If, just to take it beyond Bear Stearns and Lehman, if Goldman, or if Merrill, or if a couple other of those types of firms, did disappear as well, it certainly could lead to a much broader problem, but it's not clear that that would occur.

I tend to look at everything in terms of probabilities. So, you could ask the question, what's the probability that we would have a general collapse in the financial sector? If you asked me a year ago, I would have said that probability is as close to zero as you can get. If you'd asked me six months ago, I would have said .01 %, again very very small. Now, in my view, that probability has increased, so now, it's still not high. Is it 1%, is it 2%? That we're even having this discussion suggests it's not a trivial probability anymore, but Paulson will give you the perspective, well, you know, if this next domino goes, the whole castle comes down.

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GG: I want to focus on that, because it's really been depicted, not as a possibility or even a high probability potential, but really as an inevitability that we were days away from the entire financial system collapsing, and the kinds of financial crises that haven't been seen since the Great Depression descending immediately upon us. Is that, obviously there are all kinds of risk --

RS: I would strongly disagree with that, that contention. Again, there's the possibility that we would go there, but far from the probability that we'd go there, or high probability that we'd go there. Is it a 5% chance, is it a 2% chance? I think those are the probabilities that in my view are relevant. It's not to say that it wouldn't happen, but to say that there's a 50% chance or a 90% chance the system would collapse, I think that's being overly alarmist. I just I don't see any reason why you should, how you can come to that conclusion.

GG: Right. Now, you began by alluding to the fact that you have to be careful to be very accurate in terms of the pronouncements you make, and suggested or alluded to the fact that perhaps Paulson in particular, and maybe Bernanke as well, haven't been as careful as they ought to be in terms in accuracy. I don't want to put words in your mouth, but that's what I understood you to be saying.

Were you referencing their claims about the probability of a financial collapse in the absence of this invention, or were you referencing other things as well in terms of things you think have been of questionable accuracy in terms of what they've been saying?

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RS: The two things that I most disagreed with, that I thought were most inaccurate, were the notion that the collapse would be inevitable if the bailout wasn't passed. And the perception that they I think were trying to give, which is that it wasn't just the big New York City firms that were going to be down, that it was absolutely everyone that would be negatively impacted. And certainly if you were take the financial system and grind it to a halt, then Barney Frank on one of the Sunday shows perhaps said it best, and laid it out very explicitly, and I'm sure that Bernanke and Paulson have said basically the same thing, which is: If the financial system melts down, then you can't borrow money on your credit card; firms can't borrow money for their inventories; farmers can't borrow money to plant next year's crops. So, yes, when you take the worst case scenario, then life is very, very ugly.

But the question is, what's the probability of that worst case scenario? And unless you can tell me that that has a probability greater than a very, very small number, then we really need to calm down and take a step back from all of this doomsday talk.

One other thing I really should mention some place in here, is, the question also is, what financial instruments are we talking about? When you say that there's no liquidity in the market, and you're trying to provide liquidity in the market, what exactly are you talking about? If you want to, if you're IBM or GE or something, and you want to float commercial paper, then there is liquidity, but you're going to have to pay for it, it's going to be more expensive. So you're talking maybe a six or seven percent rate rather than a three percent rate. If you're talking about, even Fannie Mae bonds, there's a certain degree of liquidity there as well. So most of the market now has a fair amount of liquidity.

Where you don't have liquidity, is in the market for what has been derogatorily referred to among financial professionals, is "toxic waste," for four or five years, where you have not even just the mortgage-backed securities, but when you're talking about more esoteric financial instruments. For a lot of those types of instruments, there is very minimal liquidity in the market, and it's not clear however, that even $700 billion will get you out of that particular liquidity problem.

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The question that I would love to hear someone ask Paulson, is: can he state definitively how much in credit reverse swaps is currently outstanding? Or, how much in CDO's is currently outstanding? The numbers for those types of financial instruments, the credit reverse swaps, you could be talking in excess of 45 trillion dollars. So, 700 billion there, could be just a drop in the bucket. And that is the part that should scare me, that should scare you, that should scare any taxpayer; that it's not clear that, even with the magnitude of the proposal out there, if Paulson is right, worst case scenario, he doesn't have enough bucks out there to do what he thinks he can do.

GG: Well, let me ask you about that, because I'd planned to ask you this, and this is the perfect time, which is -- before this crisis really came to fruition, one of the most significant problems that the United States faced, you could actually call it a crisis as well, I think, was the staggering amount of debt that we've put ourselves under in terms of financing our military adventures abroad, and all sorts of expansions of other spending programs that we can't afford and have been borrowing from foreign creditors in order to finance -- to the point where we're under a huge mountain of debt already, staggering amounts of debt, both not just in terms of the federal deficit, but just the overall debt totals.

So when the government is talking about, or when Paulson is talking about taking $700 billion and basically transferring it to private investment banks in exchange for these crippled assets, or what you call toxic waste, where's that money coming from? And what are the options for the government to get that money, and what are the consequences of those options?

RS: Boy, where's the money coming from? The simple answer is, beat's the hell out of me. Realistically, I think the answer is, you're going to have to issue a lot more debt, at least in the short term. Treasury debt. So, another way of thinking about this bailout, is that you're going to be trading $700 billion worth of toxic waste for $700 billion worth of US Treasury bonds. And, long-term --

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GG: But, can the American public fund $700 billion worth of new Treasury bonds? Is that an instrument that can really produce that total?

RS: Realistically, yes. Realistically, yes, but with an asterisk on that. The question is, at what price? And the price would have, I think, two parts.

Number one, the obvious part, is, what's going to be the interest rate that you're going to have to pay? Currently, Treasuries are viewed as being the basically the risk-free asset, and so they carry the lowest rate around. When you start adding up a bigger and bigger pile of Treasuries, then the cost borrowing is going to increase.

Perhaps a more pernicious cost, is what economists talk about as the opportunity cost, and that is, if you're going to be borrowing $700 billion more, in the short term, what is it that you're not going to be able to do? Are you going to be borrowing to make this subsidy to the financial industry and then not be able to do health-care reform? Are you be borrowing again for finance, and not be able to address international issues in Afghanistan or Pakistan or whatever? There is a cost, beyond just the interest cost.

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Now, to take a step back, can the US afford it, in terms just of this additional debt, much of which will likely be financed by foreign investors? The answer is yes, and it's not so much an absolute dollar value that we should be concerned with; it's the dollar value of debt relative to GDP. So as long as we have a strong economy, yes, we can add more debt. I don't think we can add $700 billion worth in a year and still have as strong an economy as we would have otherwise had. But you can add some debt, you perhaps a $100 billion worth of debt, on a year in, year out basis, just given the growth in the economy and not have a problem. But we've been adding more than that of late. And so, you can do that for a year, two years, five years, ultimately it catches up with you.

GG: What about the likelihood the government is just going to start making more money in order to pay for all of that? Do you think that's likely, and what would the consequences of that be?

RS: I doubt that the Fed will start to print money. It's conceivable that the situation would get so bad where the Fed would do that, but I don't that we're... I think that the Fed is going to back up from that and simply not take that alternative.

GG: Right.

RS: I can't see that. But you could make the argument, that doing that would be less costly than doing the bailout the way it stands. The reason I guess I'm personally so opposed to the bailout is that you're looking here basically at financial assets, and you're saying, we're going to put money into rescuing the value of these financial assets. But the financial assets have value because there's a real asset underneath. And the real asset is housing.

And so, to the extent that you've had a decline in housing values, the decline in the financial asset value shouldn't be a surprise to anybody. There just shouldn't be a surprise there. But when you put a bailout on the financial asset, not on the underlying problem, it's like saying, hey, I have an infection, so I'm going to put a Band-Aid on a cut. It doesn't work; it doesn't solve the underlying problem.

GG: How about the alternative that has been floated by Chris Dodd and some of the leading Democrats, that in exchange for the $700 billion, instead of buying these deeply troubled and potentially worthless assets, that instead the government take an equity stake in these companies? Does that address some of the most significant concerns that you have about the Paulson bailout plan?

RS: Yes and no. The, I think that I've just been through the Dodd proposal very, very quickly, and I think the Dodd proposal does address a lot of the issues that have been raised, in particular in terms of equity stake rather than just all bonds, number one, and number two in terms of having much more oversight. But the problem basically is that you're competing on Paulson's playing field, and I don't think it's the right playing field.

GG: So, the question then becomes, if the Paulson framework is just fundamentally misguided, such that adding some oversight provisions and improvements on to it the way that the Democrats seem intent on doing, doesn't really get to the core deficiency, what do you think is the right approach? Does the government, if you had your way, if you had the kind of powers, the monarchical powers over our economic policy that Paulson is seeking, would you just have the government stand still and do nothing in the short term, or is there a different sort of emergency approach that you believe can get at the underlying problems that you think would be wise?

RS: Well, the underlying problem is fundamentally with - well, let me take a step back here. There are two fundamental underlying problems. Number one is the value of the housing stock is gone down, therefore anything related to the value of the housing stock also will have gone down. If you view the problem as being related largely to the drop in the value of housing stock, then you need to do something to stimulate that. You may not want to do that; you may not want to validate a bubble in the housing stock but again, you simply don't have a choice. So, my first step would be to say, we have a problem with lower values of housing, lower wealth by consumers as a whole, we need to address that, and we need to step in and stimulate the housing sector. That's number one.

Number two: there is a problem in terms of liquidity in some aspects. And the problem with liquidity largely stems from a lack of knowledge and a lack of regulation, that trading CDO's and CRS's and whatever now, these very very difficult, difficult to impossible. And so you have a lot of people that are very much concerned that they have obligations in their portfolio that they're basically stuck with. They may not be able to value those obligations, and yet they can't get them off the books. The way we get into this mess was - Senator McCain has said greed - that's a small part of the story, but unfortunately the larger part of the story is, is that there's no regulation on this greed, that anyone can go out and do basically whatever they want in some areas of finance. It's the wild west.

And it's those areas where you have this lack of liquidity. So, you can't very well say, hey, let's go out and continue this deregulation. The areas that are most regulated - regular banks, and TRIF's, have the least problem. The areas that are least regulated have the most problems.

GG: Now, and beyond that, there's obviously this debate -- you'll have some people on the right who are objecting to this plan who will actually argue that the problem is still excess regulation, and the solution is further deregulation, and of course you have, I'd say a much larger group of people, who are recognizing the fact that the industries that are most troubled are the very one that have become most deregulated.

But leaving that debate for the moment to the side, is there any dispute about what the trend has been over the last few decades, especially in these troubled industries? Have these industries become progressively more regulated, or progressively more deregulated over, say, the last 15 to 20 years?

RS: Certainly over the last 30 years, you've seen a substantial deregulation in finance, and I think generally the deregulation has had positive effects. We've had much more ability to have financial innovation, which is, this substantially helped the US economy. But, again, you need to have - when I think of regulation, you need to go all the way back to Adam Smith. Adam Smith emphasized regulation in terms of setting the integrity of the market. And when you're looking at buying and selling mortgage loans, that market has some liquidity, and it has some integrity. When you look at market for credit reverse swaps, there are no rules, and there is no liquidity.

GG: Well, let me ask you that question, because you can actually go back a lot of years, and find pretty dire warnings about what was happening within these unregulated industries. Warren Buffet has the famous 2002 shareholders report where he calls them financial weapons of mass destruction, and warns pretty presciently that what has happened was going to happen as a result of these incredibly complex instruments that even he said he was incapable of valuing despite having studied them a great deal, and that they were basically insusceptible to valuation - they were too complex to be understood, let alone valued and regulated, and at some point, this complexity and this interdependence was almost certainly going to lead to the kind of collapse the government is now warning about.

So it's hard to say that a lot of this was unanticipated -- so what about the people who are now offering their expertise up as our salvation, led by Hank Paulson? Were they largely people who have been warning about the problems of deregulation and these derivatives, or were they people who were kind of participating in their exploitation and growth?

RS: Unfortunately, Mr. Paulson was among those who were creating the problem, rather than warning about the problem. In his role as CEO of Goldman Sachs, Goldman under his watch created a whole lot of CDO's that are now --

GG: "CDO's" meaning, "collateralized debt obligations."

RS: Exactly

GG: The kind of instrument that we've been talking about.

RS: And a lot of them now would be under the heading of toxic waste. So, it's amusing in a twisted way to look at him now as the one that's going to save us from imminent financial collapse, which was, at least in part, brought on by the actions of Goldman in terms of being so liberal in their willingness to create new and improved collateralized debt obligations.

GG: Now, one of the things that I find interesting, and this will be the last question because we're running out of time, is that, as I just referenced the fact that none of this was really unanticipated. There were warnings in lots of different places, the kind I described Warren Buffet as having issued in 2002. And the people involved in these derivative products who have become so wealthy as a result obviously had to understand the basic principle that the bubble couldn't expand forever, that at some point it was going to go down - the simple rules of physics and economics.

What is it you think that accounts for the recklessness, despite that? Was it the idea that, do you think that the people who drove that process believed that at the end of the day they would be protected from true apocalypse, because they would make the argument successfully that they were too central to the entire financial system to be allowed to fail? Do you think that was part of what the motivation was?

RS: If that was part of it, then they should go back and rewrite Machiavelli's The Prince, because they did it a whole lot better than Machiavelli could have ever dreamed of doing it. Frankly, I wish I could give them credit for being that devious, but I think they just screwed up. I think it was in part arrogance, and hubris, but I think fundamentally they made a mistake. The mistake is - it's a bit technical - the mistake is when you're looking at any one of these financial instruments, there's a distribution of returns. And, you can look at the bulk of that distribution, and say pretty well what it looks like. What you can't say is what the tail of the distribution looks like. Those very extreme tails. What will happen under very extreme circumstances, the good or the bad? So, typically, those tails get under-analysed, under-reported, and when you do end out on one of the tails, then life as you know it ceases to exist. And that's basically where we are on lot of those financial instruments today.

But I think it was more a lack of appreciation for the tails of the distribution look like. We forgot - I mean, the savings and loan crisis, in some respects was very, very similar to what we have now, and fundamentally that. We forgot the Keating Five, let alone forgetting the Depression of the 1930s.

GG: Yeah, I guess, it's interesting to me it's almost as though, it's very similar to the way in which we forgot the lessons of Vietnam immediately prior to Iraq. It's almost as though, enough time elapses, and things are stabilized and those lessons get suppressed, and we just keep making the same mistakes repeatedly.

Well, Professor Richard Sheehan at the University of Notre Dame's Department of Finance, it was a very interesting discussion - I appreciate your taking the time to talk to me today.

RS: You're quite welcome.

[Transcript courtesy of Thames Valley Transcribe]


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